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Thursday, 28 February 2013

A bit of humor today in the graph of the week section. A friend of mine living in Canada has sent me this short "paper" entitled: "Japan's Phillips Curve Looks Like Japan", by Gregor Smith from Queen's Economic Department.

It turns out that it really does look like Japan:

How funny is that? To be fair he had to reverse the unemployment rate to get the mirror image of the initial result (which was a standard downward sloping Phillips curve - in the shape of Japan of course).

Here's a map of Japan (included in the paper) to verify the comparison:

Tuesday, 26 February 2013

On Friday night the UK was given, for the first time in history, a downgrade of its credit rating, from AAA to AA1, announced by one of the rating agency oligopolists - Moody's. Here is their explanation:

"1. The continuing weakness in the UK's medium-term growth outlook, with a period of sluggish growth which Moody's now expects will extend into the second half of the decade;

2. The challenges that subdued medium-term growth prospects pose to the government's fiscal consolidation programme, which will now extend well into the next parliament;

3. And, as a consequence of the UK's high and rising debt burden, a deterioration in the shock-absorption capacity of the government's balance sheet, which is unlikely to reverse before 2016."

Two things should be taken into consideration regarding the rating downgrade. Firstly, we should be aware of the fact that before the crisis the rating agencies were giving AAA ratings to what later turned out to be junk bonds (everything from Greek debt to MBSs were considered to be a risk-free asset), thereby completely misinterpreting the market risk of such assets. However, this had more to do with the issue of the rating agency oligopoly position, their erroneous business model and false assumptions on certain assets and markets, but most importantly the artificial demand created for AAA-rated securities before the crisis (more on that here). Nevertheless they still do provide investors with some kind of reference point on the plausibility of a country’s economic policy to end the debt crisis

Second, this downgrade shouldn't be thought of as something inherently negative for the British economy. It will affect the government’s long term borrowing costs, but it won’t have a significant effect on households. It is by no means a signal for more fiscal stimulus (something that should be evident to any reader of Moody’s downgrade explanation). On the contrary, this should only create a stronger initiative for the British government to start with real structural reforms, and a proper way to conduct a fiscal consolidation.

Going back to Moody's conclusions, all these things stand. Britain does have unsustainable levels of government debt, medium-term growth prospects are terrible, and is close to repeating the woeful 1990s Japan approach.

Unfortunately, the Chancellor seems to have missed the message. He interpreted it only from one side of the coin: that Britain needs to persist in dealing with its debt. This is absolutely true. However, the other part of the coin implies the change of course of economic policy in Britain. Simultaneously decreasing the tax burden and the regulatory burden along with substantive reorganisation of the inefficient labour market to tackle declining British productivity, are good ways to start. In other words, using the Swedish approach as opposed to the Japanese approach (two countries that experienced a similar structural shock in the beginning of the 90s, but had very different responses and very different outcomes).

A rating downgrade for Britain shouldn't cause the same effect as it did in the US in 2011. However, in current times, it acts as a good signal of external enforcement to a government that seems to be missing more and more targets. It's a shame that it won't be interpreted as such, but that it will just go down as a reaffirmation of a faulty approach in a pointless political quarrel.

"...all Italian voters know that Berlusconi owns the major commercial TV network since the early eighties. We exploit exogenous variation in viewers' exposure to Berlusconi bias using idiosyncratic deadlines to switch to digital TV from 2008 to 2012. At the deadlines, old analogue signals were switched off and only digital signals kept on airing. ... Most digital channels are aired by new media companies, which have no ties to Berlusconi. After switching to digital TV, many Italian households changed their viewing habits. From June 2008 to June 2011, the share of viewers of Berlusconi-controlled channels dropped from 84% to 71%. ... We explore the causal effect of the shock to bias exposure on voting behaviour at regional elections in March 2010, the first elections held during the switch-off process. ... This setup allows us to compare the electoral outcome of Berlusconi’s party between municipalities that were exposed to the new digital channels and those where the digital switch-off had not taken place yet. In order to make the comparison more credible, we compare municipalities close to the switch-off geographical boundary. These municipalities are only a few kilometres apart, and they differ only in terms of access to the new television technology.

Although the control of most pre-digital outlets by Berlusconi was widely known, the switch caused a drop in his coalition vote share by 5.5 to 7.5 percentage points. This effect is economically and statistically significant. Scaling the effect by 2005 Berlusconi supporters and non-voters who watched new channels in 2010, we estimate that at least 30% of them changed their voting behaviour after the switch-off of analogue TV. The effect was stronger in towns with older and less educated voters. At least 30% of digital users had not filtered out the bias from 1994 to 2010."

They apply a robust strategy to compare the municipalities with and without exposure to digital channels, allowing them to control for a range of possible unobservable characteristics, and tend to refer to it as a quasi randomized experiment (*in econometrics, the closer you can get to observing a randomized experiment, the better). Even though their results are very strong and suggest that the switch of the media bias did have a significant effect on Berlusconi votes, there still could be a possibility of an omitted variable bias that could have led to this change in voting patterns.

However, one needs to keep in mind that Italy is a specific example in which media bias was playing a particularly important role, simply due to the fact that during Berlusconi's primeministership he managed to control most of it. This is why Italy is a fruitful filed for a range of political economy research that looked at how this media monopoly and its necessary bias in favour of Berlusconi affected his party's electoral chances. Here is a working paper from Larcinese (2005) that showed how voters who watched Mediaset (Berlusconi's private media company, largest in Italy) were much more prone to vote for Berlusconi in the 2001 elections (the second time he won office). Even though this could be explained by initial ideological divergence of those who choose to watch it in the first place, the results do imply significant effects of media control on electoral outcomes. This becomes even more important when taking into consideration that after seizing power more strongly (Berlusconi's first primeministership lasted a bit more than 6 months, while the second one lasted for 5 years), he got more control over the public broadcasting company RAI, thereby completely monopolizing the media market. Similar to Larcinese's paper is this one by Durante and Knight (2009) which draws similar implications for ideological exposure of Italian voters to news programs.

Italy is definitely not a stand alone case. A very good paper addressing this media bias effect in the US is by Della Vigna and Kaplan (2007) "The Fox News Effect: Media Bias and Voting", QJE (the link is for their 2006 working paper), which has found that the introduction of Fox News has gained the Republicans from 0.4 to 0.7 percentage points in the 2000 elections in towns which broadcast Fox News. They have also found that Fox News convinced from 3% to 28% of its viewers to vote Republican.

Enikolopov, Petrova and Zhuravskaya (2011) find similar implications in Russia, where independent TV decreased the aggregate vote for the government party by 8.9 percentage points, for the 1999 elections. In a slightly different paper observing media capture by politicians (so a case close to Berlusconi), McMillan and Zoido (2004) looked at how Peru's president Fujimori was able to bribe the media, the judges and the legislators and thus keep himself in power for a long time (until this was discovered by one media owner that didn't sell out). In the paper they list the amount of bribes Fujimori was paying to some judges and newspapers.

There is a whole range of other papers observing this relatively new and under-researched field of political economy - the role of mass media on policy outcomes. For anyone interested more deeply in the subject, I recommend Prat and Stromberg's (2011) overview of the current literature.

Going back to our first paper, it will be interesting to write a follow-up taking into consideration the results of today's (and tomorrow's) elections in Italy. Simply to see whether the effect of the switch to digital TV has made a lasting influence. However, this will be hard to do since in the meantime Berlusconi had lost a lot of support due to other things (like almost bankrupting the country in November 2011, for example). But without doubt Italy will still provide us a lot of potential research on the media bias story in years to come.

Thursday, 21 February 2013

One of my friends pointed out to me a very interesting new paper examining the technical competence of economic policy- and decision-makers. A brief version is available on VoxEU, while the whole paper is here.

They are concerned with the issue of should policymakers be experts in their fields (should we have more technocrats?). An issue particularly interesting in times of crises (they find a 22% higher probability that a central bank president would be a PhD economist appointed during a crisis - this was realized in ECB; Mario Draghi, who holds a PhD in economics from MIT replaced Trichet who has a political science degree).

This pattern of degrees shows some very strange findings for certain countries. For example, it would seem that in countries like Chile, Poland or Mexico it's almost mandatory to have a finance minister and a central banker being a highly trained economist. On the other hand it's amazing that developed countries like the UK or Japan have never had a PhD trained economist running the finance ministry, and only in a few cases did the finance minister had some basic economic training. This is one of their findings btw: that new democracies appoint substantially more trained economists than old ones.

I guess in the UK case, it matters more of the competence of the people around you - as suggested by Sir Humphrey Appleby paradox. So as long as the people beneath the minister, working at the Treasury are highly trained economists, it doesn't really matter who your boss is - his role anyway is to promote political goals. Besides, the Treasury Secretary has long been a political position in the UK, where this function basically ensures you the position of No.2 in the Cabinet, and the next likely PM (Gordon Brown is an example). But some basic understanding of economics should exist for a person who wants to run a country's tax system, and make it easier to do business - perhaps this is why in the UK the tax system is so complex - every new Treasury Secretary has his own ideas of new rates, so the system got fully cramped by now.

For a PM, this isn't surprising, I've rarely heard of a prime minister being a PhD economist - politicians in general tend to be people who have law degrees (I remember some political economy papers testing political career models - Diermeier, Keane and Merlo, 2005 is one of them - and in their summary statistics the share of politicians holding a JD, LLM or equivalent was always around or higher than 60%). So with PMs it's more surprising to see countries who had a lot of PhD trained economists serving as PMs - Slovenia seems to lead the way, where 70% of their PMs had some economic training (have in mind, the country gained independence in 1991). I guess this didn't stop Slovenia's huge economic problems - perhaps the PMs were all "bad" economists - applying wrong pre-crisis and during-crisis economic policies. Slovenia is also interesting because it had more PMs educated in economics than their central bankers (again, it's a short time series to observe, so we're basically talking about a dozen people).

Central banking however puzzles me completely. Isn't this suppose to be where we would employ technocrats? Again, just like with a finance minister, perhaps it matters that the people employed know what they're doing more than what the boss does.

Sunday, 17 February 2013

Continuing with the discussions on monetary policy, I ran across an article at VoxEU by Ester Faia, Wolfgang Lechthaler and Christian Merkl on the ineffectiveness of monetary policy in heterogeneous European labour markets (here's the paper - it's a DSGE model). In particular they look at the link between large hiring costs in-between Eurozone economies (which are a proxy for unreformed labour markets) and policy trade-offs for central banks. The argument is that within a monetary union with heterogeneous labour markets (as evident on the graph below), monetary policy can be completely ineffective unless some sort of harmonization of firing costs across countries is achieved. This means that unless European labour markets all don't undergo a reform similar to the German Agenda 2003, it isn't likely that ECB's monetary easing will be very effective in decreasing unemployment.

I'm not entirely sure whether their argument is supposed to be a sort of an explanation of the European liquidity trap (on how monetary policy is ineffective in a crisis) or is it supposed to be another justification of the idea that we can't have a monetary union without a fiscal union? What I'm certain however is that according to their main finding...

"A central bank facing higher firing costs should, thus, allow for larger deviations from its long-run inflation target to reduce this externality. Thus, the mandate of the ECB to solely maintain price stability is associated with welfare costs. To be more precise, a pure price-stability policy (i.e. stabilising inflation at its target) is suboptimal."

...they would assume that the ECB should opt for more monetary easing and a switch towards a higher inflation target (something close to NGDP targeting), however, they are unfortunately unable to do so due to the between-country differences in the rigidities of their labour markets (if I got this right).

The externality of which they speak is the following:

"By hiring a worker today, firms reduce the future pool of applicants. This implies that firms hiring tomorrow will on average have to employ workers with lower productivity. We show that this negative composition effect cannot be offset by standard wage-setting mechanisms (neither collective nor individual). Thus, optimal monetary policy should be designed to reduce the macroeconomic effects of this externality."

I have a big problem with this assumption, as it fails to account for the new emergence of productive individuals on a yearly basis (new graduants, people switching jobs, etc.). I fail to see how this assumption is justified as an externality which is supposedly best fixed by monetary policy. If this is their main assumption for linking labour market inefficiency with ineffective monetary policy, then the conclusion fails the robustness test. A more plausible explanation would be that rigid markets with higher firing costs and stronger protection (like Portugal, Spain, Greece or France in the graph below) react more slowly to signals sent from the monetary authorities (or any other signals for that matter). This could perhaps explain why it takes a lot of time for both reforms to kick in and price signals to work in these countries, since businesses fail to adapt more successfully due to existing legal burdens.

The graphs shows a strong negative relationship between output volatility and the employment protection index (based on employment legislation), suggesting that economies in which labour markets are too rigid are less likely to experience output fluctuations both upwards and downwards. This is logical since an inability of companies to adapt faster to exogenous shocks (both positive and negative) means that the fluctuation of total output will be slower.

Finally they conclude with the following point:

"This implies severe complications for the Eurozone. With its large differences in firing costs, the monetary policy for the average Eurozone is not appropriate for every single country. Thus, there is a need for the harmonisation of firing costs. The divergence in the monetary transmission mechanisms due to the differences in labour-market institutions impairs the efficacy of the ECB’s policy. Without harmonisation, firing costs increase the tensions that are already present within the Eurozone."

Going back to my previous arguments, if we want to see an effective monetary policy (or stabilization policy in general), we first need to think of structural reforms of a rigid labour market and the regulatory environment. The authors of the paper in my opinion are on a good track in reaching such a conclusion, but operate under dubious assumptions of defining the labour market institutions.

Wednesday, 13 February 2013

I’ve been involved in an interesting discussion with a libertarian Croatian economist, Petar Sisko, on the consistency of market monetarism and their ideas on how to kick-start a recovery. He runs a very interesting blog called Money Mischief (it’s in Croatian, but his post where he responds to my earlier text on MMT is in English).

Libertarian Croatian blogs are not such a rarity (there is a very good one by Nenad Bakić – Eclectica, it’s mostly on capital markets, investments and analyses of stock portfolios but some
topics revolve around the systematic instabilities in Croatia as well), however whenever I run into one I get positively surprised. Others include Monopolizam, Usporedbe, Austrijanci, Cronomy, etc. (if anyone has other good examples, please let me know).

If you want to follow the
debate step by step, I recommend first reading my article on Market Monetarism,
then Petar's detailed response, and then the text you have before you. This is how
the debate commenced so it’s good to start reading it in the right order. (I
especially recommend this to my students, as this will be one of the lectures
we will cover in the Principles of Economics course - yes it's time we adapt our curricula to new ideas)

Also, I enjoy the opportunity to have discussions on blogs this way. After all, this is what blogs are for. Have in mind that the market monetarism idea has originated primarily from the blogosphere. This is just one of the examples of how new technologies change even the way on how we think about economics.

I will
write today’s blog as a direct response to Petar. Here goes:

(Continuing
from the comment I left on your blog)

I don’t
have any problem with the first part of your argument in emphasizing the
importance of rules vs. discretion. My
problem is on the perception of the rule itself (NGDPLT) as a credible enough
mechanism to pull us out of a recession. I’ll explain what I mean by this.

In the first paragraph you mention the following:

“You could wait for the politicians to resolve all these things, but they haven’t been ready to make the right moves in the past, so why should they do it soon? This way CBs can help in stabilizing the environment, and even give an impulse to AD after acknowledging the elevated money demand is a reason to act, but again, in my view trough a rules based framework and not discretion.”

This is the point. Politicians haven’t been ready to make the right moves in the past (Berlusconi in Italy and Zapatero in Spain from August to November 2011 are the perfect examples) as they received easing from the ECB in order to give them time to do reforms, and they did nothing.

So if this is the case why should the ECB provide funds to irresponsible governments? After the events from the end of 2011, both Italy and Spain changed governments and slowly and partially (Spain more slowly than Italy) undertook some reforms. It wasn’t after Draghi’s speech in July that made things stable again. But with all this support, what we can see in Spain and Italy today are lower bond yields, which slightly relieves off the pressure, but we don’t see improvements in fixing the structural shock and changing the growth model. There is still no credible enforceable mechanism that will insure the proper set of institutional reforms taking place. (I will soon take a look at the business and consumer confidence indices and how they have responded to Draghi’s speech. In the previous twotext I looked at them, monetary easing wasn’t all that helpful).

In my opinion things like these are just buying time for the politicians to avoid having to undergo the necessary reforms, as these can be very politically costly, even in times when the voters are ready to accept painful solutions. This brings large implications of the moral hazard problem.

On business expectations

"MMs see NGDP as the indicator of the monetary policy stance. They believe credible signal about NGDP in the future, starting from now, would be able to improve conditions. Markets would in that scenario also do big part of the heavy lifting, without much need for large programs (remember CHF moving after the 1,20/EUR announcement without SNB moving a finger, or Euro yields after Draghi’s “magical” words). Businesses mostly don’t make investment decisions based on the actions of the central bank, and they shouldn’t, they ought to care about the relative price signals. Monetary policy should be the one that doesn't affect relative prices."

I’m still not convinced in how the credible signal is suppose to affect businesses in expecting lower uncertainty in the future and induce them to start hiring and spending now. Also, I still don’t see how is it going to affect consumers to spend more.

I can see clearly how the signal affects the bond markets, thus only bringing reliefs to governments and entities who own government debt. But if the governments don’t follow up on the reforms, there will be no point in these signals and they could lose their credibility, right? Well, yes and no. The ECB’s actions will never lose credibility, but they also won’t be able to remove the restrictions of rigid labour and investment markets. Not even with external enforcement towards sovereigns.

It’s about raising demand

"MMs don’t think that policy will be achieving the target by raising inflation. Its not about inflation, its about demand - the idea is to create a "hot potato" effect, where public will hold more money than they want to - and spend it. If there is talk about inflation, it is a talk regarding Feds target of 2%, and Fed is failing to hit its own target as well. But they do know that current spending is strongly related to expectations of future incomes, and that’s why the credible income target is set, if possible using the futures markets to target the forecast. As I already mentioned, markets will do a big part of the heavy lifting then."

Ok, I accept this notion – it’s about demand. However, as I’ve emphasized before, I don’t see the “hot potato” effect occurring. I’m not convinced that the population will accept this effect as the permanent one, no matter how long the Fed pledges to keep long-term interest rates low, or how long they are determined to continue with QE. It’ precisely the expectations of future income and future uncertainty that are preventing more spending and investment today. I think that the credible monetary policy signal is not enough. It can bring us short-term relief, but sooner or later markets will start wondering what was done as a result.

The fiscal stimulus arguments operate under the same logic – that current stimuli will affect future expectations and incentivise consumers and businesses to spend money today. In a previous text I align with Noah Smith on that issue in his response to David Beckworth:

"...note that if fiscal policy is effective (i.e. if the multiplier is high), then aggregate demand will depend not just on current deficits but on expectations of the response of deficits to future external AD shocks. This is a central tenet of the "market monetarism" that Beckworth espouses, but there's no reason that forward-looking expectations can't be applied to fiscal policy as well as monetary policy."

The graphs and the structural shock

After the graphs, you follow upon with this:

"So we see that NGDP, as employment, was stable for more than a year after the subprime problems started surfacing. I think this shows that the reallocation between sector that were hit structurally and other sectors that needed new workers (employment kept growing) was happening in a stable environment until 2008. The adjective “great” has accompanied this recession only in the mentioned Q3 of 2008 when Fed for various reasons and policy errors failed to react to the growing money demand causing a fall in the NGDP causing the “Great” Recession."

In 2008 the trigger for the nominal shock was the Lehman collapse. The housing market decline was an introduction to the piled up systemic instabilities that became visible once Lehman went under (I’m referring to the faulty finance model, the recourse rule, and high hidden systemic risks as a result of regulatory inducements)

When I say structural shock, I’m mainly concerned with the unsustainability of the pre-crisis growth model (particularly in Europe), and the accumulation of hidden systemic risk which was given momentum by the regulatory rules like Basel or the recourse rule, and encouraged banks to fill their balance sheets with toxic assets like MBSs in the US, or Greek debt across the EU. In addition to the huge problems in the financial industry, a variety of other convergence problems arose in the EU, with declining productivity and rising real wages, within a system supported by foreign debt accumulation and growing current account deficits used to fund unsustainable political concessions.

So my definition of structural instabilities ranges from a variety of factors. The graphs you show should tell us of a certain lag between the crisis on the housing market and when the system finally collapsed. MMTs believe that this was due to the Fed's tight money at the time after the Lehman bancrupcy. This could be true, but by 2008 what happened was that the crisis became evident to much more people as more and more houses were facing foreclosure. With the flawed financial system falling apart people experienced a huge wealth shock, and it was this shock that still disables them from proper recovery in consumption. The failure of the financial system pre-crisis model which became evident to more and more people in 2008 was what caused a downward spiral leading to a credit squeeze.

As I’ve said before: "…I have no problem in using NGDP targeting over inflation targeting as a monetary policy strategy in the long run (I’m particularly intrigued by Sumner’s ideas on an NGDP futures market which would make monetary policy more market-based and remove the ‘central planning’ characteristic of the Fed and make it more supervisory), but I don’t see it effective as a short-run stimulus to start-up a recovery."

It’s the different definition of the shock that caused the crisis. Structural shocks to the economy tend to be easily misinterpreted as aggregate demand shocks. According to St.Louis Fed chief James Bullard, in the 1970s a productivity slowdown was similarly misinterpreted as a structural shock. Wrong policies to combat it resulted in rising unemployment and rising inflation in the 70s, that wasn't fixed until Paul Volcker. Now it's a bit different since we're not experiencing rising inflation, but this I feel is because the shock today was much different than it was in the 1970s.

This is what Scott Sumner tends to emhphasise quite a lot. There is a difference in how we see the shock. If we interpret it as a purely AD shock, then NGDPLT could prove to be effective. If we define it as a structural shock, then structural reforms are required to fix it. Monetary policy perhaps can make things easier and less messy then they are now (to paraphrase your concluding sentences) but it cannot be seen as the only mechanism to pull us out of the recession.

Sunday, 10 February 2013

The Economist produced a graph on crowdfunding and what works and what doesn't on the biggest crowdfunding site Kickstarter. For those unaware of this recent technological phenomenon, crowdfunding is a collective funding platform for individuals who use networking to pool money and fund their creative ideas and projects. It is usually done online and is used to support a variety of activities. It is a great way to replace more formal and traditional funding techniques. It is literally funding by crowds of people.

How does it work? People who have innovative, great ideas or projects, but lack the funds to finance them, "upload" them online on a specialized site and that way enter a relatively large market of potential investors. Depending on interest and the idea itself, a variety of individuals fund the project, and naturally bear a certain risk, but also expects a payoff. I don't know how crowdfunding sites get around the problem of intellectual theft, but I'm sure they've come up with something.

And if anyone thinks that crowdfuning is still small and couldn't be used to fund big projects, the numbers claim the opposite:

"LAST year more than 18,000 projects were successfully funded on Kickstarter, the largest crowdfunding website. A total of $320m was pledged by 2.2m people, making possible creative projects including a documentary on fracking, a home aquaponics kit and a community centre for circus arts. Games, a category which includes video, board and card games, received the most support, with $83m pledged to more than 900 projects. Given their high development costs and passionate fans, video games are a good match for crowdfunding, particularly as established publishers churn out ever more sequels, leaving a long tail of unmet demand (see article). In all, 44% of the projects launched last year managed to raise the money they requested, but the success rate ranged from a threadbare 26% in fashion to a sprightly 74% in dance. Seventeen projects raised more than $1m apiece in 2012. Technology projects received the highest average pledge by category, at $107 per backer. The biggest Kickstarter project to date is Pebble, a watch that connects to a smartphone via Bluetooth, which received almost $150 per backer to raise $10.3m in May. (The first finished products are due to be delivered to backers next week.) According to Kickstarter, the total amount raised last year increased by more than 200% compared with 2011. Having opened itself to British-based projects in October, the site expects to see further growth in 2013."

I am always in favour of such innovative ideas that can help fix existing market failures, particularly if the idea is originated within the market itself. As Arnold Kling says: "markets often fail, that's why we need markets". The idea of crowdfunding, as it is with many new technological improvements, is among the best possible proof of this. When there is a downturn in the credit market, and banks are highly restrictive of lending and borrowing due to tight conditions which seems to lead us to a self-perpetuating vicious cycle, a new idea comes along, generated by the market participants allocating information and comes up with an innovative solution.

It's all about quality as only the best perceived projects get funded, i.e. projects that offer a good value for money, or are simply a great idea (some campaigns and charities get funded as well). Crowdfunding is, in my opinion, the future of financing successful projects. For a technological visionary (which I'm not but many people are) it's not hard to imagine that sites like Kickstarter will soon enough replace banks (or at least take a big portion of their assets). This is excellent for at least two reasons: (1) more projects get funded that probably wouldn't have received funds in a traditional way, and (2) banks get more competition, which forces them to adapt or perish. The final outcome will be mutually beneficial for all market participants - we get more new ideas in more quickly, and more people are able to fulfill their entrepreneurial dream.

Wednesday, 6 February 2013

The image of Nordic countries has too often been one of high spending, big size of government, a huge welfare system, basically a social-democrat paradise. But are their policies all that social, or are they much more pro-market than people are prepared to believe?

Their model has changed from promoting an equal society to promoting both an equal and dynamic society, where competition strives and market forces are abundant (as opposed to some Anglo-Saxon nations which carried this distinction in the past, but not anymore). This is a great message to Europe which doesn't have to look too far to find a model that comprises both a competitive economy and high levels of social mobility.

"The main lesson to learn from the Nordics is not ideological but practical. The state is popular not because it is big but because it works. A Swede pays tax more willingly than a Californian because he gets decent schools and free health care. The Nordics have pushed far-reaching reforms past unions and business lobbies. The proof is there. You can inject market mechanisms into the welfare state to sharpen its performance. You can put entitlement programmes on sound foundations to avoid beggaring future generations. But you need to be willing to root out corruption and vested interests. And you must be ready to abandon tired orthodoxies of the left and right and forage for good ideas across the political spectrum. The world will be studying the Nordic model for years to come."

I've been advocating such an approach to reform for quite some time (recall all the times I pointed out Sweden's 1992 reforms as a lesson to Eurozone economies). An approach which will be based on achieving a more dynamic society but also a society that stresses great importance on social mobility, where no matter where you come from, you will have an equal opportunity to succeed. To change this type of culture within a society (the informal institutions) you need to change the formal institutional model, where political accountability needs to prevent cronyism, where entrepreneurial incentives won't be destroyed by state regulations, where unemployment will stay low because labour market rigdities are removed, where innovation and investments are incentivised through booming competition, where competition is the basis for performing all public sector services, from schooling to health care, and finally where the legal framework is efficient and focused on preserving the rule of law.

The Nordic model is not perfect. It isn't without flaws and problems of its own, but so far it's the closest thing we have to a dynamic, innovative yet equal society that features all of the conditions above.

Government size

As for their size of government, it's all about individual preferences towards what the state should or should not do, and how efficient is the state in fulfilling those preferences. As I've written before it's not so much about state size, it's more about state efficiency. Big governments aren't big because of their size, but because of their size relative to efficiency in providing public goods like the rule of law, enforcement of contract, private property and a just legal system.

However in certain countries there are individual preferences towards more or less redistribution, preferences that get allocated on the political market via elections, and which translate into electoral winning coalitions.

But what if the politicians don't do what the voter preference aggregation implies? For that we need a stable institutional system to provide a safety net for the public, strong enough to oust the politicians or to prevent them from a rent-extracting behaviour in the first place.

Freedom matters

However, what I always admired about the Nordic model is their persistently high scores on Freedom indices:

This table sums it up better than anything. On a weighted index of the most important factors measuring a country's economic success (competitiveness, ease of doing business, innovation, corruption, HDI, prosperity), the four Nordic countries take up first four spots! Followed by Switzerland, New Zealand and Singapore, with the US holding 8th place (corruption and prosperity seemed to have held them back). This is what is implied by good governance and stable pro-growth institutions. If any country is seeking a pattern on how to take itself out of the crisis, look no further than this table and improve as much as you can in all these indicators. Each country will use different ways to apply the reforms, but the message is clear: freedom matters.

Saturday, 2 February 2013

There is a paper by Ishii and Wada from the Peterson Institute for International Economics, that focuses on Japan's fiscal packages and why they haven't worked in the period from 1992 to 1996 - in times of their immediate response to the aggregate demand shock (which was really a structural shock to their booming economy).

Here is what they say:

"Our main finding is that, from 1992 to 1996, real discretionary fiscal spending was merely 21 trillion yen in public works. This is about two-thirds of the officially announced public works spending during the period. Meanwhile, tax revenues declined by about 33 trillion, which is approximately equivalent the total officially announced tax cuts. A closer look reveals that the local governments, not the central government, failed to spend announced discretionary fiscal spending. In addition, there is evidence that much of the public work was geared toward projects of dubious significance. However, the key to solving the mystery of Japanese fiscal packages is the awkward and fettering fiscal relationship between the central and local governments."

Their argument is supposed to be something like: don't blame the central government - they tried everything they could, blame the local government for the stimulus not working.

But that's actually the point when you think about it. All the money gets distributed to local firms and local projects. In that process the inefficiency of local agents (politicians and bureaucrats) will disturb the effect of central government policies. This is true not just for the stimulus but for a number of laws and rules that get passed. Basically, the more detached a country's local government from its central government, the less likely a stimulus would work.

Their findings on low quality public spending and the fact that public investments didn't lead to growth can tell us a lot on the effectiveness of the stimulus in the real world, outside the Keynesian fiscal multiplier model. It tells us (1) that bureaucrats cannot provide a a better evaluation of who should get government funding than market actors themselves. They don’t have any responsibility on distributing the funds and they don’t have any obligation (or knowledge for that matter) to make an effective decision over who gets the funds.

Furthermore, (2) on a local level corruption and cronyism get into the picture where local politicians hand-pick the projects they would like to see go through. This is far from a market allocation mechanism. And this is the elementary reason why a fiscal stimulus will be ineffective. It will mostly give money to favourable enterprises who enjoy political support, thus furthering their inefficiency and lack of adaptiveness.

This was one of my biggest questions for the proponents of fiscal stimuli: Why would they expect that the model version would work in a world with imperfect agents? Particularly if these imperfect agents lack real accountability?

Moving away from the pre-crisis instabilities

Raghuram Rajan has an interesting article on Project Syndicate on that issue from another interesting angle:

"The neo-Keynesian economist wants to boost demand generally. But if we believe that debt-driven demand is different, demand stimulus will at best be a palliative. Writing down former borrowers’ debt may be slightly more effective in producing the old pattern of demand, but it will probably not restore it to the pre-crisis level. In any case, do we really want the former borrowers to borrow themselves into trouble again?

The only sustainable solution is to allow the supply side to adjust to more normal and sustainable sources of demand – to ease the way for construction workers and autoworkers to retrain for faster-growing industries. The worst thing that governments can do is to stand in the way by propping up unviable firms or by sustaining demand in unviable industries through easy credit."

This is the exact position this blog has been advocating from the start - move away from the pre-crisis unsustainable growth model and think of the enduring crisis as a structural shock, not an aggregate demand one. This will imply a long recovery, but at least it will enable the markets to adjust and restructure.

Rajan accounts for this and doesn't forget Japan:

"Supply-side adjustments take time, and, after five years of recession, economies have made some headway. But continued misdiagnosis will have lasting effects. The advanced countries will spend decades working off high public-debt loads, while their central banks will have to unwind bloated balance sheets and back off from promises of support that markets have come to rely on.

Frighteningly, the new Japanese government is still trying to deal with the aftermath of the country’s two-decade-old property bust. One can only hope that it will not indulge in more of the kind of spending that already has proven so ineffective – and that has left Japan with the highest debt burden (around 230% of GDP) in the OECD. Unfortunately, history provides little cause for optimism."

No, not even in the zero lower bound

Some time ago Tyler Cowen wrote a great post on the fiscal multipliers and the ZLB trap in an open economy, to which Scott Sumner reacted in claiming that the New Keynesian theory cannot explain neither Japan or the UK. They both dismantle the idea that expansionary fiscal policy can be effective because of the zero lower bound.

This, I feel, is the basic point I was trying to make in my previous texts on fiscal multipliers and fiscal stimuli as a way to boost the economy (see here, here, and here). It is summed up by paper from Fujiwara and Ueda:

"Incomplete stabilization of marginal costs due to the existence of the zero lower bound is a crucial factor in understanding the effects of fiscal policy in open economies. Thanks to this, government spending in the home country raises the marginal costs of home-produced goods, which increases expected inflation rates and decreases real interest rates. Intertemporal optimization causes consumption to increase, so that the fiscal multiplier exceeds one. While government spending continues, the price of home-produced goods increases more than that of foreign-produced goods. Expecting that two countries are at symmetric equilibrium when government spending ends, the home currency depreciates and the home terms of trade worsen on impact when government spending begins. That shifts demand for goods from foreign-produced goods to home-produced ones. The fiscal spillover thus may become negative depending on the intertemporal elasticity of substitution in consumption."